Doomsday hedging

For the past six months, the currency market has not been kind to its traders. In the euro market, we were accustomed to having about 80 pips of noise on the four-hour chart before a trend developed, but now we have seen, in this jerked-around-flight-to-quality environment, intraday price swings of up to 3¢, 300 ticks or pips. The week before Thanksgiving 2008 saw prices rise and fall a total of approximately 7¢ or $7,000 on a $100,000 position.

This is a lot of intraday volatility, particularly viewed in the context of the trend evident on the four-hour euro chart from Oct. 20, 2008, though Nov. 26. The market is firmly range bound with huge whips in intraday price volatility.

Further, while the currency markets traditionally have not been correlated to the U.S. stock market, this has not been the case in the near recent past: correlations between the U.S. dollar and the Dow Jones Industrial Average are above 90%. It may be that the currency markets, with the exception of the Japanese yen, are caught in a flight-to-quality mind set that has instigated a large volatility premium.

DEALING WITH VOLATILITY

Trading acute price volatility in any market, especially a range-bound market, requires a trader to be extremely nimble. It is also the case that in these circumstances value-at-risk and notional limits may be blown due to intraday price and volatility ranges, and not because of a developing trend. For the traders of N3Q to manage these extreme events in a new hedge fund developed in May 2008, the company instituted two simple but powerful strategies called doomsday hedging and doomsday management.

The N3Q team was worried about a market crack in October 2008 and a resulting flight-to-quality trade. In 1987, we noted that the two-year Treasury note yield stood at 3.80% on Oct. 19 and dropped as low as 2.99% one month later. We believe this occurred because investors must acquire U.S. currency to purchase U.S. Treasury notes, which prompts a flight-to-quality situation in currencies. N3Q looked for a similar indication of liquidity risk from the past history of two-year yields.

In 2008, the two-year Treasury dropped below 2% on Sept. 29 and by Oct. 3, it was 1.60%. On Nov. 26, the two-year stood at 0.98% (all quotes from the Federal Reserve). Anticipating a flight to quality trade that would temporarily distort any trends in the four-hour euro market, doomsday hedging was employed to lock down the books.

Both doomsday hedging and doomsday management are implemented in the context of trend trading. When black swan events, such as the ongoing financial and liquidity crises occur, markets see price movements that violate some assumptions of trend trading.

Assuming that a trader’s book is not over-leveraged when these movements occur, the trader has two options: either immediately realize large losses or lock in these same losses as unrealized, while hedging the book and allowing the market to recalibrate at a new level. Because crises are, by definition, of relatively short duration, this should take a relatively short time (two to four weeks) to play out. After a new trend or range has been established, the trader can pay for the unrealized loss that was locked in, balancing it with realized profits.

In “Perilous play” we can see that a new range was established between $1.24 and $1.32, approximately two weeks after the doomsday hedge.

N3Q decided to hedge the entire book amid the flight-to-quality risk at $1.3300. Long positions were not lifted because using the flight-to-quality risk, would have a life span of approximately one month. Also, in reviewing the four- hour chart, there was a possibility of a retracement to 1.4200 by year-end and the average returns of the fund needed to be protected.

CALCULATED RISK

The “Doomsday calculator” shows a simple spreadsheet that calculates the point at which the trader should hedge the book (open an equal number of short and long positions), given the following assumptions:

1) No funds will be deposited into the account

2) The account needs 20 pips of spread protection — the bid/ask spread may widen to 20 pips (normal is 1.5 pips) due to low liquidity, and the account must have adequate equity to avoid a margin call due to a wide spread.

3) The account requires adequate equity to pay three days’ roll. During the liquidity crunch, overnight borrowing costs increased more than tenfold.

4) Each lot (E, F) is a 100,000-unit lot.

5) The trader will require 60 pips of maneuverability between doomsday and the point where the account will receive a margin call.

The doomsday hedge position allows the trader to continue to make money around the hedged position as he awaits the resumption of a tradable trend.

The math underlying the doomsday hedge spreadsheet is relatively simple. In this example, the spreadsheet takes inputs A through I and determines how far the market will have to drop (in our example, the book is long $8.4 million notional) before it violates the model’s requirements for spread protection, roll protection and 60 pips maneuverability.

To determine the violation point, the model first calculates the point at which a margin call will be required — that is, when usable margin equals zero. Using the above example, we are long $8.4 million; thus, each pip that the market moves against the position costs $840. Therefore, the margin call hits at 1,190 (1 million / 840 = 1,190) pips from the current market price. The margin call will occur at $1.3300 - $0.1190 = $1.2110, as indicated on the spreadsheet.

Next, the calculator determines how far above a margin call the trader should institute his doomsday hedge by converting spread and roll protection to pips, adding 60 pips (maneuverability protection) to this number, and adding the result to the blowup point. This is the point where the trader sets his protective shorts to hedge his book. Again, from our example:

• Roll protection = 56 pips per day = 288 pips per three days (triple roll is charged on Wednesdays).

• Maneuverability protection = 60 pips.

• Total pips required for protection = 48 + 288 + 60 = 394 pips.

The doomsday point is therefore set at 394 pips (3.94 ¢) above the blowup spot of 1.2110, or at $1.2503.

The spreadsheet shows how conservative these assumptions are. The account would receive a margin call at $1.2110, but the calculator calls for it to be hedged at $1.2503, preserving $330,000 of usable margin. This safety margin is the sum of the model’s requirements for roll protection, spread protection and maneuverability.

While N3Q Inc. trades in the spot market and does not employ options, given the above situation and a range-bound market, it may be necessary to construct synthetic long-option straddles. A traditional long-option straddle is being long both a put and a call at the same strike. The owner of a long straddle makes a profit if the underlying price moves a long way from the strike price, either above or below. The trader profits on one leg of the straddle, leaving the other leg to expire worthless.

Absent options, a book may behave like a synthetic long straddle if the trader manages the range around the doomsday hedge and takes directional bets around the middle of the range. This position has been traded as if the euro market will rebound somewhat above the range after the flight-to-quality issue has been resolved.

Using the range previously indicated on the candlestick chart, the table in “Dancing around the range” (above) illustrates the trading plan within this range. Notice that given 95% confidence statistics, the data illustrate fatter tails on the upside, which means it is possible that the euro will move upward once flight-to-quality issues are resolved.

Initially, on the downdraft move from 1.3300, Fibonacci numbers are used to calculate a possible 50% retracement of the entire move from the low of 1.2404 back toward 1.3300. The precise average of the actual four-hour range is 1.2728. We use one standard deviation away from the average to indicate the management of long and short positions. We are looking to stockpile money so that when the euro moves above 1.3250, we can be out of our doomsday hedge and realize a greater profit than if we had closed our initial long positions at a loss when the market fell through 1.3300. Further, we have protected our return and have maximized the use of our usable margin.

Therefore, when the euro is at or below 1.2556, we monetize our shorts (that is, lift them), and then let the market float back to the average where we replace our short positions. When the market is at or above 1.2900, we monetize our longs and then let the market float back to the average to replace our long positions. We are managing the position in the range.

The credit and liquidity crisis of fall 2008 drove the currency markets off kilter, interrupting trends and disrupting correlations. When these events happen, a trader should look to lock up a book in a doomsday hedge and take the time to examine the fundamentals and technicals of a market to determine the next steps. The trader can then trade around the position while waiting for a tradable trend to develop. Trading under duress does not produce profitable results, and doing nothing is rarely a profitable option during such volatile times. Doomsday hedging gives a trader time to think.

Leslie K. McNew is managing trader at N3Q Inc. and a clinical professor of finance at Hanley Group Derivative Trading Center, University of Dayton. E-mail her at lesmcnew@gmail.com . Dr. Tup Ingram is a trader at N3Q Inc. E-mail him at tupingram@gmail.com